Thursday, 22 March 2012

Not All Investors in Bonds have Lost Money

While some countries such as Greece have been terrorized by the bond markets, the governments of other countries have seen the interest rates on their debts fall to record lows. So while some bond investors have been losing money in Europe, there have been others who have raked in good returns.

There can be considered to be a large pool of money which moves around the global financial markets looking for the highest returns. This pool of money is made up of pension funds, cash from wealthy individuals, as well as sovereign funds run by various countries. The money typically follows a predictable pattern over the business cycle – to shares and other risky investments when times are good and to bonds and other safer investments during a downturn.

This time around, the severity of the recession has heightened the sense of fear in the market and investors have become picker about where they park their money during the slump. This coupled with the high level of debt that many governments (and companies) took on-board during the boom time has resulted in the sovereign bond market being split into winner and losers. The previous post dealt with the losers. But if money is to be invested in bonds during the recession and some governments and many firms (considering all of the bankruptcies) are out of bounds, it has to go somewhere and it goes to the winners.

And the winners have been the governments of the US and the UK among others. The interest rates on 10-year government bonds for both countries have fallen below 2.0% to record lows. Along with investors seeking safety, the reduction in interest rates has also been driven by the central banks buying large quantities of government debt as part of their efforts to lift the respective economies out of their slump.

But the thing that investors are asking now is whether bonds will remain popular. When the global economy starts to pick up again, investors will be willing to take more risks. And the buying by the central banks is near an end. The Federal Reserve in the US has not suggested that it will again buy more bonds issued by the US government even though the Bank of England has committed itself to buying more UK government debt. Furthermore, not many investors will be happy with a return of 2.0% in comparison to recent strong gains made in the share market. Rallies in both the share market and the bond market is a contradiction that cannot continue for too long and either the optimist buying shares or the pessimists sticking with their bonds will be proven wrong.

However, despite some signs of better prospects for the global economy, there are some who still think that interest rates for these bonds have further to fall. If the economic recovery is weak, the factors that have been driving the rally will continue. Then, a return of 2.0% and more gains in bond prices (interest rates and bond prices move in opposite directions – see the previous posting) may be a clever bet if things turn out for the worst. This is where those bankers are supposed to (but don’t always) earn their exorbitant pay packets.